In December 2007 as the
and global economies were careening off the cliff, Fed Economist Dave Stockton
reportedly stated that the economic outlook for the U.S. economy was "benign…[and projections
were] unimpaired and on nothing stronger than many late nights of diet Pepsi
and vending-machine Twinkies." What
a prophetically ironic metaphor seeing as Diet Pepsi has succumbed to PepsiCo's
collapsing market relevance in the face of their arch-rival Coke and Twinkies,
the preservative laden fluffy pastry, is bankrupt. Add to that the Center for Science in the
Public Interest's report in March 2012 that 4-methylimidazole (that caramel
coloring that makes cola's their distinctive donkey urine on a Grand Canyon
hiking trail color) is a carcinogen with the average soda can containing over
500% of the State of California's public safety benchmark and it's not really
surprising that we neither diagnosed the condition leading to the much
ballyhooed Global Financial Crisis (GFC) nor have we taken any meaningful
corrective actions to fix it.
While most of the Eastern seaboard was dealing with the almost storm that almost happened to almost dump a bunch of snow on us here in Charlottesville (yes, I wanted a bit more than the dusting we received) the Federal Reserve set a new record with U.S. Treasury and mortgage holdings at a whopping $2.946 trillion (with a "t")! And with Atlanta Fed President Dennis Lockhart's dire prediction that "large scale asset purchases" are likely to be necessitated due to the sluggish economy in 2013, this all-time intervention record is likely merely the qualifying line for records that will be smashed throughout the year. In the Olympics of financial intervention, we've got our Usain Bolt without the Jamaican charm. Let the games…begin?...continue?...whatever!
Two wrongs don't make a right. That goes for Twinkies being sloshed down with carcinogenic Diet Pepsi; a GFC manifest in mortgage debt abuses being resolved with mortgage debt abuse; and the architects of a disaster being entrusted with its remedy. And while I'd love to delve into the precise economic policy issues illuminated in Fed's January 16th record setting 'asset purchase' report, I thought it might be informative to land this commentary a bit closer home. The intervention of the past few years (suppressed interest rates and Fed purchase of mortgages) actually have grave implications for all of us. The penny of pain deferral in the moment comes at a pound of agony later. And, ironically, this pain will respect no asset class being felt more in its magnitude by those with the horded most.
Many of us hear about the foreign ownership of
representing about 1/3 of the total public debt - with popular demonization of
certain large Asian holders. The Federal
Reserve and U.S.
public institutions including Government Sponsored Enterprises (GSE) hold just
over 40% while the individual consumer / investor (represented by pension
funds, insurance companies and mutual funds) hold about 12%. On the present trajectory, we could see the
Federal Reserve owning about 1/3 of the mortgage market by 2014 (if it
continues its current purchasing policy) and about 2/3 of the longer maturity
debt issued by the Treasury. Unlike
investors who invest earned dollars and seek investment returns for actuarial
income required in their projection of the monetary future needs they'll face,
the Fed's 'asset purchasing' behavior is based on its ability to buy using its
own whimsical capacity to buy. Far from
a 'fair market' buyer, the presence of a fiat buyer actually alters price
Imagine the following scenario. You and I go to the grocery story to buy a $1 loaf of bread (o.k., seriously, we know that it's not even a muffin at today's prices but work with me!). When you pay for your bread, you use a dollar from your wallet. When I pay for my loaf, I use a dollar from a Monopoly game. Both 'dollars' are accepted by the grocer who, in turn, deposits both in the retirement account for her employees. By having non-par 'dollars', the immediate effect on the asset (the bread) is that I have effectively devalued it. But worse than that, when, in the future, the employees withdraw their retirement account, they'll have far less than expected. In fact they'll have not just half but the half less the unearnable return that they did not receive on the non-par dollar. And this is the good news. The bad news is that the Monopoly money actor - not investing for retirement or future returns, will liquidate their non-investment as a function of their extenuating need - not as a function of the asset appreciation. This yield decoupled sale could artificially flood supply onto the market and drive down the price. In the case of the Fed, there is the added complexity in that they have competing financial instrument interests. Depending on the timing of their sale of Treasuries or mortgages, their sale of one (given the fact that they are holding long-dated Treasuries and long-dated mortgages - both 30 year), the price drag of their sales will decrease the book value and liquidity of pensions, insurance payment capacity, and other cash flow considerations of the average citizen.
In the Panic of 1893, President Grover Cleveland turned to J.P Morgan to loan gold to the U.S. Treasury to keep it from collapsing in exchange for 30 year bonds with a 4% interest rate. Twenty years later this private capital means of financing the public debt was institutionalized with the formation of the Federal Reserve. During this tumultuous time, private investors wielded considerable advantage as they not only owned the operation of the government but they also controlled the means of production and commerce (the actual productivity of the
economy). Setting aside the morality of
this dynamic - I know, that's a bit hard to swallow, but bear with me - the
good-old-days model concocted by J.P. Morgan and his allies was far more robust
than the unimaginative approach taken by the Fed today. Morgan could actually insure his repayment by
aligning his self-interest to the industrial production of the country. By purchasing competing, non-productive
assets at equivalent durations, the Fed is doubling down on the exact same
factors that triggered the GFC in the first place. Remember that the GFC - mislabeled a
'mortgage crisis' - was the consequence of pairing consumer debt (accessed
through cheap money second mortgages) actuarial risk with real estate asset
risk. While the symptom showed up
looking like mortgage influenza, the actual virus was unsustainable debt fueled
consumption. By suppressing interest
rates through contrived purchases and by effectively undermining real asset
value, we're actually building a bigger risk than the GFC of 2007-2008.
There's a 'real value' super-storm brewing. While the leading bands of the storm will be filled with the windy bluster of debt ceiling posturing, the real eye of the storm is brewing around the paired devaluation effect of Fed balance sheet intervention. If unaltered, the resulting illiquidity for pensioners, the insured, and investors alike will directly harm the economy for the actuarial debt maturity horizon - the next 30 or so years. Once again, it's time for each of you, and those about whom you care, to become more conscious about the harm being done by passivity in your investment management and start aligning the capital you steward to things that actually unleash the productivity of yourself and others. The last time the private banking sector managed this process, we got a Great Depression and a World War. If a few self-serving actors can co-opt the system for their nefarious purposes, it's reasonable to assume that a few actors with good intent can achieve equal effect with a more laudable outcome.